Employment painting a very different picture than most other U.S. economic data
Nonfarm payrolls increased 372,000 in June, better than the 250,000 estimate and continuing what has been a strong year for job growth. The unemployment rate was 3.6%, unchanged from May and in-line with estimates. An alternative measure of unemployment that includes discouraged workers and those holding part-time jobs for economic reasons fell sharply, dropping to 6.7% from 7.1%. The May and April reports were revised downward. Average hourly earnings rose 0.3% month- over-month or 5.1% year-over-year. Education and health services led job creation, followed by professional and business services and leisure and hospitality. The robust employment market continues to be the counter argument against the U.S. economy being in recession.
Hot inflation is forcing the Fed to be more aggressive
Inflation rose at its fastest pace since November 1981. U.S. consumer prices increased at a 9.1% annualized rate in June, ahead of the 8.8% estimate and last month’s reading. Excluding volatile food and energy prices, so-called core CPI increased 5.9%, compared with the 5.7% estimate. Core inflation peaked at 6.5% in March and has been nudging down since. Energy prices surged 7.5% on the month and were up 41.6% on a 12-month basis. The food index increased 1%, while shelter costs, which make up about one-third of CPI, rose 0.6% for the month and were up 5.6% annually. June inflation was higher than expected and counter the narrative that inflation is peaking. Gains were broad based across categories and the Fed may have to act more aggressively at its July meeting. Markets are now pricing in a 100 basis point rate hike by the Fed at its July meeting, up from 75 basis points prior to the inflation release. The yield curve further inverted on the report with rates spiking on the short end of the curve and declining (after an initial jump higher) on the longer end that is likely pricing in a potential recession.
Sources: U.S. Bureau of Labor Statistics
The Fed delivered an anticipated 75 basis point rate hike on June 15th, while also launching its plan for quantitative tightening. The Fed Funds Rate increased from a range of 0.75%-1.00% to a new range of 1.50%-1.75%. Their updated economic projections showed inflation remaining higher over the next few years while economic growth is now seen at a below-trend 1.7% this year and next, with the unemployment rate rising back above 4% by 2024. The updated dot chart implies another 175 basis points of rate increases by the end of 2022 with rates peaking between 3.5-4.0% in 2023. The Fed is committed to bring down inflation, but we believe economic and market data will drive future decisions. We expect rates to move higher, but also believe the Fed put is not dead and either a pause or rate cuts could occur if the economy slows or if markets exhibit further weakness.
Eurozone & Japan show signs of slowing further; will they ever produce any level of sustained growth?
The eurozone economy showed further signs of slowing based on the S&P Global Composite PMI. The reading fell from 54.8 in May to 52.0 in June, a 16-month low. Weighing on the performance in June was the first fall in manufacturing production for two years and a weaker rate of increase in services business activity. All major countries exhibited slower rates of growth led by Ireland which hit a 16-month low and France which hit a 14-month low. The sharp deterioration in the rate of growth of eurozone business activity raises the risk of the region slipping into economic decline in Q3.
Sources: S&P Global, Eurostat
Japan’s economy shrank at an annualized rate of 0.5% in Q1, slightly better than the preliminary reading of a 1% contraction. Consumer spending and other private demand was stronger than previously thought. One source of worry is the diving value of the yen, which now trading at a 20-year low of about 135 yen to the U.S. dollar.
Manufacturing & Service sector actively shows signs of life in China, but headwinds persist including new COVID lockdowns
China’s manufacturing activity expanded at its fastest in 13 months in June, buoyed by a strong rebound in output as the lifting of COVID lockdowns sent factories racing to meet recovering demand. The official Manufacturing PMI for China rose to 50.2 in June from 49.6 in the prior month. The smaller company focused Caixin Manufacturing PMI rose to 51.7 in June, also indicating the first expansion in four months, from 48.1 in the previous month. Looking at the consumer side of the economy, the official service sector PMI surged to 54.7 in June of 2022 from 47.8 in May. This was the first expansion in the service sector in four months and the strongest growth since May 2021. A similar jump was seen in the smaller business focused Caixin Services PMI that increased from 41.4 in May to 54.5 in June.
China’s economy has started to chart a recovery path out of the supply shocks caused by strict lockdowns, but headwinds persist, including record high jobless rate in big cities, a still subdued property market, soft consumer spending, and fear of any recurring waves of infections. Analysts expect further improvement in economic conditions in the third quarter, although the official GDP target of around 5.5% for this year will be hard to achieve unless the government abandons the zero-COVID strategy.
GDP growth has been resilient in Brazil despite massive central bank rate hikes
Brazil’s economy grew less than expected in the first quarter ahead of an expected downturn later this year, another setback to President Jair Bolsonaro as he readies his re-election bid. GDP grew 1% quarter-over-quarter, slightly behind the 1.2% expectation. In recent months, Brazil has seen a string of better-than-expected indicators such as retail and employment, prompting many economists to raise their year-end GDP projections. While Brazil is one of the few countries where GDP estimates have been on the rise, the country has a lot of potential headwinds on the horizon such as the Presidential election, high inflation, and tightening central bank policy that has already increased rates by 10%. Inflation is eating into consumer purchasing power and the result could be slower growth during the second half of 2022.
Analysts expect S&P 500 earnings growth of 4.3% in Q2, down from the 5.9% growth expected at the end of Q1. It is important to note that earnings have exceeded estimates in 39 of the last 40 quarters. Earnings are forecast to grow 10.2% in Q3, 9.4% in Q4, 10% overall in 2022, and 9.4% in 2023. In Q2, the largest earnings contributions are expected from energy, industrials, and materials companies. Earnings in the financials sector are projected to decline 24%, largely due to an increase in loan loss provisions which eat into earnings. Loan loss provisions have played a key role in bank earnings over the past few years. Consumer discretionary, utilities, and communication services are also expected to post a decline in Q2 earnings.
Are we looking at the opportunity for equity-like returns in credit?
Volatility in rates and credit spreads has increased over the past few months. IG spreads ended Q2 at 155 basis points over Treasuries, HY spreads widened to 587 basis points, and bank loan spreads rose to 655 basis points. While we do anticipate an increase in defaults across lower quality companies, the implied default rate for high yield bonds is 9.8% based on current spreads and 40% recoveries. Implied defaults are even higher for bank loans. As is typically the case, markets have likely overshot on default expectations, potentially creating a near- term opportunity for equity like returns in credit.
The charts and information in this presentation are for illustrative purposes only, and are based upon sources of information that Sunpointe, LLC generally considers reliable, however we cannot guarantee, nor have we verified, the accuracy of such independent market information. The charts and information, and the sources utilized in the compilation thereof, are subjective in nature and open to interpretation. FOR USE WITH INSTITUTIONAL INVESTORS AND INVESTMENT PROFESSIONALS ONLY. NOT FOR PUBLIC DISTRIBUTION. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.